Wednesday, March 10, 2010

Let's have a simple conversation about debt to help understand some of the confusing numbers.

Imagine someone makes $1,075 per month and they spend $3,284 per month.

That means they are spending 3 times what they make. They have to borrow $2,209 on the credit card just to survive and get to the following month.

Are you with me?

During the month of February our government collected $107.5 billion and they spent $328.4 billion.

They are spending 3 times what they make. They had to borrow $220.9 billion this month just to survive and get to March.

This is a record monthly deficit. To put this into perspective, the deficit for the entire year in 2008 was $460 billion, an all time record before it was smashed in 2009.

It was $220.9 billion this month.

The average interest rate on the debt this month was 2.5%: an all time record low.

The Federal Reserve currently has the Fed Funds rate at 0%, and they are a major buyer in the treasury market. If they were to even hint that they were thinking about raising rates, or slow their treasury purchases, rates would surge. How high would they go?

As recently as September 2007 the average interest rate on US treasury bonds was at 5%. Back in 1980, rates were at 15-20%, so 5% is considered historically low.

If rates were to just go back to that low rate of 5%, with the estimated $14.3 trillion in total debt at the end of 2010, then the yearly interest cost would rise to $500 billion annually next year. That is only the interest.

The Federal Reserve cannot let interest rates rise. They are boxed into a corner. My guess is they are already purchasing a far greater amount of treasury debt than they are telling us.

I wrote last week that the Greek riots would be a preview of America's future as government promises go unfulfilled. I did not expect that to come as early as this weekend, as Students at the University of California’s flagship Berkeley campus took to the streets on Friday night, vandalizing university buildings, burning trash cans and clashing with police in the latest expression of frustration over cuts to the educational budget in California.

Sunday, March 7, 2010

Massive news out of China this weekend from the governor of the People's Bank of China, who said the days of the "special yuan" were numbered. By this he meant the peg of the Chinese yuan to the value of the dollar in the currency markets. He described the dollar peg as a temporary response to the global financial crisis.

The last bastion of hope for the US currency is its peg to the strength of the Chinese yuan. Now that they have stopped purchasing our debt, the removal of the peg will be the final step before the dollar sinks into oblivion.

The announcement could have been sparked by the CBO's upated budget projections that I discussed earlier this week. In the new projections Obama has planned massive tax cuts with no mention of spending reductions. Translation: "China, we plan to make the value of your dollar denominated reserves as close to zero as possible."

Before I begin I want to emphasive the fact that I do not look at the coming American real estate and stock market crashes as something to be upset about. I look at them as opportunities.

America's democratic free market structure provides the greatest long term investing environment in the world, and in this great country there is no question that real estate is the best long term investment one can own.

American assets are about to be priced at values that will never be see again in our lifetimes. I am not mad about this, in fact I get up every morning extremely excited to prepare myself for these coming buying opportunities.

I do not own gold and silver because they are the best long term investments. In actuality, they are the worst by far. However, there are small periods throughout history when they revalue themselves to represent the currency supply growing rapidly. This is one of those times in history.

I do not own the precious metals or their mining company shares because I want to give them to my children. I own them because doing so will allow me to purchase the greatest amount of income producing real estate in the future. I can't wait to sell them.

In a normal environment real estate provides educated investors with the absolute greatest opportunities. The good news is that the already low prices are about to get even lower. I'd like to explain why using the recently released Congressional commercial real estate report, but before I do, I'd like to talk a little about what commercial real estate is, and give some real life examples of what is happening in the market today.

Commercial real estate is defined as any multi-family building with 5 or more units, office, retail, or industrial/storage space. There are a few main factors that separate commercial real estate from residential, and the differences are important to understand how the coming crisis will unfold.

The most important difference is the way they are priced. Residential property prices are determined by the selling price of local comparable properties. If your neighbor sells their house for X amount, that is used directly to determine the value of your home.

Commercial real estate value is determined by only one factor: the income the property generates.

Investors then look at that income stream and determine how much they are willing to pay for it. For example, let's say that a property generates $100,000 per year in income after expenses. If an investor needs a 10% return on their money every year, then they will pay $1,000,000 for the property. The 10% return is known as a cap rate, something you will be hearing more about as commercial property enters the crisis.

The second major difference between commercial and residential is the way they are financed. The bulk of commercial real estate is financed on a 30 year monthly payment schedule (similar to residential), however, commercial loans have "terms" between 3 and 10 years meaning after the term expires the property needs to be refinanced.

For example; you bought an apartment in 2005 with a 30 year fixed loan with a 5 year term. Every month you pay a 30 year payment, but in 2005 the loan comes due and you must pay off the entire loan amount or refinance. While prices falling drastically have hurt the commercial market considerably, it is this financing schedule that will bring on the apocalypse.

Okay, now let's apply what we've learned to a real life example.

This week down here in Charlotte BECO property group purchased the Meridian office park. The property was bank owned after entering foreclosure in 2008.

The property was originally purchased for $150 million with a $120 million loan.

BECO's closing price: $42 million

This means that the bank will have to "write down" $78 million on their balance sheet to represent the loss after the sale. ($120 mill loan - $42 mill purchase price = $78 million loss)

The banks are reluctant to take these losses and sell the properties because many do not have enough capital in reserve. For example, if this bank had only $50 million in reserves and they were forced to sell this property and take the $78 million loss, the FDIC would show up at their door and close the bank.

Now that you understand how commercial real estate is valued and have seen a real life scenario, let's take a look at the size of the coming problem......

Between 2010 and 2014 $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half of these loans are under water, meaning that the property is worth less than the mortgage. Property values have fallen over 40 percent since their peak in 2007, and they continue to fall every month as we move forward.

The fall in value occured due to an increase in vacancy and a decrease in rents in buildings across the country as the economy deteriorated.

Income Down - Building Value Down

The following chart shows the increased vacancy in all property types:

The following chart shows the falling rent prices in all property types. (Many commercial leases are locked in for long terms so this number will accelerate downward later in the crisis window)

Taken together, these two factors have led to the sharply reduced values of all commercial property as can be seen below:

The impact of commercial real estate losses will be felt most by small and community banks. While these banks packaged and sold most of the residential loans originated to wall street, they kept the majority of the commercial real estate loans on their books.

Only the highest quality of commercial real estate loans were purchased by wall street and packaged into loan pools. This means not only did they keep the majority of the loans on their books, but they kept the more risky loans that were created.

The fact that there is $1.4 trillion in debt that needs to be refinanced over the next few years with most of those properties underwater already seems like an insurmountable task.

However, when you look deeper you can see that the problem is actually greater. The credit market for commercial real estate has dried up completely. The CMBS "loan pool market" that was available from wall street only a few years ago has completely disappeared. Couple that with the fact that banks are severely undercapitalized, and their ability to take on new loans or refinance is essentially non-existent.

This is the reason that the FDIC is going from door to door every Friday night and shutting down banks. We haven't seen anything yet. It is a downward spiral in that the inability to refinance reduces prices further, thus making it even harder for new loans to refinance.

Let's bring this all together and talk about why commercial real estate may soon become the greatest investment opportunity of our lifetimes.

As I hope you know by now our country is both broke and bankrupt. I believe a day of reckoning is fast approaching where the government is going to have to make some hard choices on both what they spend new money on and what cuts they will have to make to their unfunded promises.

Their first and foremost goal as politicians to get re-elected.

When the spending spree finally ends, I believe they will be forced to spend money exclusively on necessities; defense spending, social security, and medicare (although far reduced from what they spend today).

What Americas do not need to survive are artificially inflated commercial real estate prices. If the people find out that they are bailing out the wealthy investors who overpaid for buildings while they starve on the streets, there will be civil unrest.

I believe that the government's funding crisis is not 20 years away like many project, but will occur in less than 24 months during the heart of the commercial real estae refinancing crisis.

During this period they will be forced to make the correct decision, which is to bundle the loans together and sell them into the market to investors at drastically reduced prices. Not only is this the correct decision for the economy but it is also far more likely due to the fact that the majority of commercial loan losses will come from the smaller banks, not the major banks that have their hands deep into the pockets of politicians. (These large banks were hurt far worse by the subprime crisis, which is why the tax payers stood ready to bail them out during the fall of 2008)

A bundled loan package that is sold out into the market was used back in 1990 during the savings and loan crisis. The program was called the Resolution Trust Corporation. I believe there will be an RTC Part II.

This will be the moment investors need to be prepared to buy; fear will be everywhere. As I stated during the prologue, I am working every day to prepare myself for this opportunity, and I assure you that I will inform you when these opportunities arrive. (More information coming upon the arrival of FT Real Estate that you will be able to access from the side bar on the right)

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and but she will never sit down on a cold one either."

- Mark Twain

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait."

- Charlie Munger

"Live as if you were to die tomorrow. Learn as if you were to live forever."

- Gandhi

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel."

- Jim Rogers

"Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

- James Grant

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

- Ben Bernanke, March 2007

"Everything that needs to be said has already been said. But since no one was listening, everything must be said again."

- Andre Gide

"When people are getting richer and richer but they're not actually producing anything, it can't end well."

- Louis CK

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could."

- Rudiger Dornbusch

"I don't write about what I know. I write to find out what I know."

- Patricia Hampl

"Chains of habit are too light to be felt until they are too heavy to be broken."

- Warren Buffett

"Everyone has a plan until they get punched in the mouth."

- Mike Tyson

"Interest on the debt grows without rain."

- Yiddish Proverb

"You can have comfort, or you can have value. You cannot have both."

- Jim Grant

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

-Ludwig von Mises

"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

- Howard Marks

"Whenever you find yourself on the side of the majority, it is time to pause and reflect."

-Mark Twain

"None are more hopelessly enslaved than those that falsely believe they are free."

-Goethe

"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

-John Coumarianos

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

-Jean Monnet

Requiring a central bank to print money to increase government's purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.

- Alan Greenspan

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"Do you want to sell sugared water for the rest of your life? Or do you want to come with me and change the world?"

-Steve Jobs

"I'd be a bum on the street with a tin cup if the markets were always efficient."

-Warren Buffett

"The market can stay irrational longer than the investor can stay solvent."

- Keynes

"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

-Ayn Rand, 1974

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function."

- F. Scott Fitzgerald

"All our life, so far as it has definite form, is but a mass of habits - practical, emotional, and intellectual - systemically organized for our weal or woe, and bearing us irresistibly toward our destiny, whatever the latter may be."

-William James

"Men it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

- Stephen Hawkings

"Give me control of a nations money supply, and I care not who makes it's laws."

- Amschel Rothchild

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

- Sigmund Freud

Many of life's failures are people who did not realize how close they were to success when they gave up.